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American Bar Association - Defending Liberty, Pursuing Justice

March 2008

Vol. 4, No. 2

Business Law

 

Asset Purchaser Sanctioned for Destroying Documents

A buyer purchases assets from debtors in Chapter 11 and assumes certain liabilities. The buyer is later sued for failing to pay assumed liabilities. There is no trial. Instead, a $1.88 million default judgment is entered against the buyer as a sanction for destroying the seller’s financial records three years before the litigation began. An unwelcome and costly result for the buyer, and no doubt not what the buyer expected when purchasing the assets or when the suit began. But that is what happened to the buyer in Quintus v. Avaya, Inc. (In re Quintus Corp.), 353 B.R. 77 (Bankr. D. Del. 2006).

The decision highlights what can go wrong for buyers when dealing with assumed liabilities and records maintenance. This article discusses this recent decision and then provides some practical suggestions for buyers and their counsel to consider.

The Quintus Decision

The Chapter 11 debtors sold substantially all of their assets to Avaya, Inc. (Avaya). The purchase agreement provided for Avaya to assume certain of the debtors’ liabilities not to exceed $30 million and to maintain the debtors’ records. The later-appointed Chapter 11 trustee sued Avaya for breach of contract and unjust enrichment for failing to pay certain assumed liabilities. During discovery, Avaya failed to produce the debtors’ general ledgers from the closing date, subledgers, and vendor files. The parties moved for summary judgment. Avaya sought dismissal of the complaint. The trustee sought damages for breach of the purchase agreement and judgment against Avaya as a sanction for destroying records critical to the trustee’s case.

The court granted, in part, Avaya’s motion for summary judgment and dismissed the trustee’s unjust enrichment claim, reasoning that a binding contract between the parties existed that adequately addressed their rights and duties. The court granted, in part, the trustee’s motions for summary judgment and for sanctions, concluding that entry of judgment against Avaya as a sanction was warranted.

Regarding the sanctions aspect of the decision, the court determined that Avaya had a contractual duty to maintain the debtors’ general ledgers, subledgers, and vendor files but destroyed them. The court found that Avaya deliberately deleted the debtors’ electronic records to give itself more computer space. The court also found that Avaya had not paid all assumed liabilities when it destroyed the records and that, as a result, it should have anticipated litigation over its failure to comply with the purchase agreement.

The court determined that the trustee was prejudiced by the destroyed evidence and that the severe sanction of entry of judgment against Avaya was warranted. In reaching its decision, the court indicated that Federal Rule of Civil Procedure 37, incorporated into adversary proceedings pursuant to Federal Rule of Bankruptcy Procedure 7037, authorizes a court to sanction a party for failure to comply with a discovery order. The court also indicated that a court’s inherent power to oversee litigation provides authority to sanction a party for failing to produce relevant documents.

The court noted that, prior to sanctioning a party who has destroyed evidence, the court must consider: (1) the degree of fault of the party who destroyed the evidence, (2) the degree of prejudice suffered by the opposing party, and (3) what degree of sanction is necessary to avoid substantial unfairness to the opposing party and to deter such conduct by others in the future.

In reaching its decision, the court concluded that all the debtors’ books and records, including the general ledger, subledgers, and vendor files, were relevant to the trustee’s claims and should have been preserved and produced in discovery. The court also concluded that Avaya did not merely alter evidence but destroyed it, and that the destroyed evidence went to the heart of the trustee’s suit. The court entered a default judgment against Avaya in the amount of $1.88 million. Avaya has appealed the decision.

Practical Considerations

The Quintus decision is a cautionary tale for those interested in purchasing assets, whether in the seller’s bankruptcy, or otherwise. Buyers in transactions involving the purchase of assets and the assumption of liabilities may want to consider the suggestions below in connection with their own deals in an effort to avoid the outcome in Quintus.

  • Specify the assumed liabilities and the records relevant to determining what liabilities were assumed and what assumed liabilities remain unpaid.
  • Perform due diligence regarding the seller’s records and arrange sufficient capacity to maintain them after the closing for the applicable retention period.
  • Designate a person responsible for maintaining the seller’s records and notify key personnel of their retention and need for preservation until notified otherwise.
  • Provide provisions in the transaction documents authorizing destruction of the seller’s records after the retention period. Consider providing for disposal of records before expiration of the retention period under enumerated circumstances such as full payment of all assumed liabilities.
  • If disposal of the seller’s records before expiration of the retention period is not addressed in the transaction documents, seek separate arrangements with the seller in writing to dispose of records before such period expires.
  • When you know or reasonably should know that there will be a dispute over compliance with the purchase agreement, retain counsel to advise you on related matters, including any alleged failure to maintain documents.
  • If a lawsuit or other proceeding is commenced, consider whether settlement may be a reasonable and cost-effective alternative to defending against the lawsuit or proceeding and the risk of loss and potential sanctions. In other words, settlement rather than litigation may be an appropriate resolution to the matter for your business.

Anticipate the Unexpected

Buyers purchasing assets naturally face challenges in the transaction. One challenge they may not anticipate when the transaction closes is subsequent litigation involving their document destruction and the entry of terminating sanctions against them. The Quintus decision is a reminder that such unanticipated events can and do occur. Buyers may want to consider the practical suggestions above in their own deals in an effort to avoid litigation of the kind involved in Quintus. Whether following the suggestions would have the desired effect depends on the circumstances of each particular case and remains to be seen.

James P. Menton, Jr., is a litigation attorney specializing in business litigation, bankruptcy, and creditor rights. He is a partner with Peitzman, Weg & Kempinsky LLP in Los Angeles, California. The views expressed in this article are solely those of the author.

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